FHA-backed loans: the new sub-prime disaster?

Never underestimate the power of greed. That seems to be the lesson of a story published in Business Week magazine on former sub-prime mortgage players now simply transitioning their business models to loans backed by the FHA -- and by extension, the U.S. taxpayer. From the story (hat tip: Brian McDonald):

Thousands of subprime mortgage lenders and brokers—many of them the very sorts of firms that helped create the current financial crisis—are going strong. Their new strategy: taking advantage of a long-standing federal program designed to encourage homeownership by insuring mortgages for buyers of modest means.

You read that correctly. Some of the same people who propelled us toward the housing market calamity are now seeking to profit by exploiting billions in federally insured mortgages. Washington, meanwhile, has vastly expanded the availability of such taxpayer-backed loans as part of the emergency campaign to rescue the country's swooning economy...

As a result, the nation could soon suffer a fresh wave of defaults and foreclosures, with Washington obliged to respond with yet another gargantuan bailout.

Click here for full story -- but sit down first!

States tried to warn about subprime mortgage crisis in 2003?

Now that the blame game for the financial meltdown is in full swing (Democrats? Republicans? Bush? Clinton?), it's getting harder than ever to wade through the partisan opinions out there to get a straight answer. For its part, Business Week has a story in the current issue that discusses what happened when some officials from various states tried to warn the feds about the coming crisis:

More than five years ago, in April 2003, the attorneys general of two small states traveled to Washington with a stern warning for the nation's top bank regulator. Sitting in the spacious Office of the Comptroller of the Currency, with its panoramic view of the capital, the AGs from North Carolina and Iowa said lenders were pushing increasingly risky mortgages. Their host, John D. Hawke Jr., expressed skepticism...

Click here for the full story.

Blame the Community Reinvestment Act?

There's been a lot of noise lately on the culpability of the Community Reinvestment Act (CRA), which reportedly encouraged (some say forced) lenders to make subprime loans to those who couldn't afford it in the name of increasing homeownership.

So what is the CRA? First, from a Wikipedia entry:

The CRA was passed by the 95th United States Congress and signed into law by President Jimmy Carter in 1977 as a result of national grassroots pressure for affordable housing, and despite considerable opposition from the mainstream banking community.^[1] Only one banker, Ron Grzywinski from ShoreBank in Chicago, testified in favor of the act.^[2] The CRA mandates that each banking institution be evaluated to determine if it has met the credit needs of its entire community. That record is taken into account when the federal government considers an institution's application for deposit facilities, including mergers and acquisitions after the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 repealed restrictions on interstate banking.^[3] However, until 1995 the Act was laxly enforced and banks only were required to advertise in local minority newspapers or sit on the boards of local community groups.^[4] The CRA is enforced by the financial regulators (Federal Deposit Insurance Corporation ("FDIC"), Office of the Comptroller of the Currency ("OCC"), Office of Thrift Supervision ("OTS"), and the Federal Reserve System.^{[citation needed]} It also charged the Federal Reserve System to implement the CRA through ensuring banks and savings and loans met their CRA obligations.

So what's the controversy? Again, from Wikipedia:

Some economists and financial experts have wondered if the CRA was - or at least had become - irrelevant, because it was not needed to force banks to make profitable loans to a variety of lenders.^[11][12] Economist Howard Husock writes that a CRA-connected community group The Woodstock Institute found in a survey in the Chicago-area that even banks not subject to CRA tended to loan in a variety of neighborhoods. He also criticized as an "amateur delivery system" community groups' involvement in marketing loans.^[4] Federal Reserve chairman Ben Bernanke has stated that an underlying assumption of the CRA – that more lending is always better for local communities – is questionable.^[3]

Economist Stan Liebowitz notes that the Fannie Mae Foundation singled out Countrywide Financial as a "paragon" of a nondiscriminatory lender who works with community activists, following "the most flexible underwriting criteria permitted." The chief executive of Countrywide is said to have "bragged" that in order to approve minority applications, "lenders have had to stretch the rules a bit." Countrywide's commitment to low-income loans had grown to $600 billion by early 2003.^[13] On the other hand, Professor of Law Michael S. Barr stated in congressional testimony that a Federal Reserve survey showed that affected institutions considered CRA loans profitable and not overly risky.^[14]

Congressman Ron Paul has partially attributed the ongoing subprime mortgage crisis to legislation such as the Community Reinvestment Act.^[15] A Wall Street Journal editorial argued that the law compelled banks to make loans to poor borrowers who often could not repay them and that this contributed in part to the subprime crisis.

So what's the story? Are these charges true? An blog post in BusinessWeek says no:

Fresh off the false and politicized attack on Fannie Mae and Freddie Mac, today we’re hearing the know-nothings blame the subprime crisis on the Community Reinvestment Act — a 30-year-old law that was actually weakened by the Bush administration just as the worst lending wave began. This is even more ridiculous than blaming Freddie and Fannie...

Not surprisingly given the higher degree of supervision, loans made under the CRA program were made in a more responsible way than other subprime loans. CRA loans carried lower rates than other subprime loans and were less likely to end up securitized into the mortgage-backed securities that have caused so many losses, according to a recent study by the law firm Traiger & Hinckley (PDF file here).

Finally, keep in mind that the Bush administration has been weakening CRA enforcement and the law’s reach since the day it took office. The CRA was at its strongest in the 1990s, under the Clinton administration, a period when subprime loans performed quite well. It was only after the Bush administration cut back on CRA enforcement that problems arose, a timing issue which should stop those blaming the law dead in their tracks. The Federal Reserve, too, did nothing but encourage the wild west of lending in recent years. It wasn’t until the middle of 2007 that the Fed decided it was time to crack down on abusive pratices in the subprime lending market. Oops.

Better targets for blame in government circles might be the 2000 law which ensured that credit default swaps would remain unregulated, the SEC’s puzzling 2004 decision to allow the largest brokerage firms to borrow upwards of 30 times their capital and that same agency’s failure to oversee those brokerage firms in subsequent years as many gorged on subprime debt. (Barry Ritholtz had an excellent and more comprehensive survey of how Washington contributed to the crisis in this week’s Barron’s.)

There’s plenty more good reading on the CRA and the subprime crisis out in the blogosphere. Ellen Seidman, who headed the Office of Thrift Supervision in the late 90s, has written several fact-filled posts about the CRA controversey, including one just last week. University of Oregon professor and economist Mark Thoma has also defended the CRA on his blog. I also learned something from a post back in April by Robert Gordon, a senior fellow at the Center for American Progress...

Business Week on "the housing abyss"

Arguing that the measures taken so far to prevent an overly large erosion in housing values have fallen flat, Business Week asks what can be done to avoid falling to the bottom of the 'housing abyss:'

The housing crisis is entering a new and frightening stage. On June 24, Standard & Poor's announced that the S&P/Case-Shiller 20-City Home Price Index had fallen more than 15% in April from a year earlier. Adjusted for inflation, the decline is the biggest since 1940-42, according to data collected by Yale University economist Robert Shiller.

The risk for the financial system and the economy is that the price drop, already horrifying, will start feeding on itself. When home values fall low enough, hard-pressed homeowners become less able or less willing to keep paying their mortgages. That forces lenders to repossess homes and then dump them back on the market at fire-sale prices, which depresses prices further and leads to even more foreclosures...

Efforts by the private sector and government to stop the slide before it gets out of control haven't done the job. Poorly designed mortgage securities rife with conflicts of interest, as well as legal disputes over priority between creditors, are forcing many homes into foreclosure needlessly, accelerating the market decline.

Sure, Congress is expected soon to pass a huge legislative package aimed at preventing needless foreclosures and stimulating first-time home purchases. But many analysts and advocates are already warning that more dramatic measures will ultimately be required. "The depth of pain is not being registered in D.C.," says Mike Shea, executive director of nonprofit advocacy group ACORN Housing in Chicago...

...the housing optimists have systematically misjudged the market. Some became convinced that the huge runup was justified by fundamentals such as population growth, rising incomes, and land scarcity. And because sharp national housing price declines are so rare in U.S. history, analysts assumed that prices would, at worst, flatten out for a few years...

What they forgot was that markets can overshoot on the downside just as easily as on the upside, with both financial and psychological forces feeding the decline...

...the fall in house prices is so precipitous that it is changing homeowner psychology, eroding the long-held taboo against walking away from a home. In hard-hit markets such as Las Vegas and Phoenix, many homeowners are beginning to conclude that their home purchase comes with a "put option"—the right to hand the keys back to the lender if things don't work out. Indeed, risky payment-option ARMs that allow unpaid interest to be added to the principal, 70% of which were issued in California and Florida, are going bad even before they reset upward, as homeowners see trouble ahead and bail. "Commercial real estate borrowers have always looked at things this way. Consumers simply caught on to the game," says Tom Lindmark, a managing director of Phoenix-based Metropolitan Real Estate...

Mass foreclosures accelerate a neighborhood's decline, triggering a spiral of abandonment and decay. A survey of agents this year for Inside Mortgage Finance by Geosegment Systems and Campbell Communications found that about half of foreclosed properties have significant damage, which reduces a property's value by about 25% (e.g., $100,000 on a $400,000 house). Ruined floors and carpets, holes in walls, and missing appliances lead the list...

Who can fix this mess? Certainly not lenders. They're part of the problem. To repair their damaged balance sheets, they're aggressively reducing lending. And they haven't geared up for the wave of defaults...

What more might government do? The Federal Reserve has already intervened heavily, of course. In addition to slashing short-term interest rates, it has extended more than $150 billion in secured loans to banks. Anything more from the Fed would leave it open to charges that it was subsidizing the banks and raising the risk of inflation...

If the housing market continues to weaken, action in Washington could heat up next January, when a new President and Congress take office. The next President, whether Democrat or Republican, will have more flexibility to be bold because he will be starting with a clean slate, although Barack Obama has taken a far more interventionist stance than has John McCain...

But expect strong pushback on that last idea from fiscal conservatives. The Wall Street Journal's editorial page observed on June 21 that the FHA lost $4.6 billion last year, making it a less-than-obvious candidate to guarantee billions in troubled loans.

Option ARMs expected to unleash the next wave of defaults

At first glance, the Option ARM loan seems like a great product, but only if it's used responsibly. In the past, it was tapped by astute borrowers who had a varied income (such as salespeople and the self-employed), who could elect to pay a minimum amount during some months (like on a credit card) but then make up for the shortfall when more money was available. What it wasn't intended for was as a gambit in which borrowers pay only the minimal amount and hope to refinance as housing prices rose (as least not officially). But brokers really pushed these loans, as they paid far higher commission than the traditional 30-year fixed variety.

According to an article in Business Week, the the next housing crisis -- and wave of foreclosures to hit the market -- will be the result of Option ARMs re-setting, either as the result of higher interest rates or because the borrower, through negative amortization, has added so much to the loan balance that it's triggered a re-set to a fully amortizing loan:

With the subprime mortgage crisis already crippling the U.S. economy, some experts are warning that the next wave of foreclosures will begin accelerating in April, 2009. What that means is that hundreds of thousands of borrowers who took out so-called option adjustable-rate mortgages (ARMs) will begin to see their monthly payments skyrocket as they reset. About a million borrowers have option ARMs, but only a fraction have already fallen due.

That was the catch to option ARMs; borrowers were offered low initial payments that would recast higher after several years. Many home buyers thought they could resell their homes before their payments increased. But instead, many of them got trapped. According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Some of these loans have already started to recast. About 13% of option ARMs that were issued in 2006 were delinquent by 60 days by the time they were 18 months old, Credit Suisse said...

Among the states expected to be worst-hit is already battered California. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse. Option ARMs were especially popular in the state, where they were heavily marketed during the boom by such companies as Countrywide Financial (CFC) in Calabasas, Calif.; Washington Mutual (WM) in Seattle; and Wachovia (WB) in Charlotte, N.C. Moreover, on top of their ARMs, many homeowners also refinanced their homes, driving themselves even deeper into a debt they thought they could escape by flipping their homes.

But California won't be alone. Homeowners are also frighteningly vulnerable in states such as Arizona, Florida, New Jersey, and others...

The option ARM loan defaults could accelerate next year even if subprime defaults subside, said Chandrajit Bhattacharya, vice-president and mortgage strategist at Credit Suisse Securities. He said California will see the bulk of the option ARM foreclosures and the rest will be spread out across the country...

Option ARMs, which were originally designed for self-employed people with fluctuating incomes, gained popularity with other workers during the peak of the real estate boom in 2004, when rapidly rising home values would have otherwise kept many buyers out of the market.

The loans, which were generally given to borrowers with better-than-subprime credit, give homeowners the option of making a minimum monthly payment, which covers none of the principal and only a portion of the interest, the rest of which is added to the loan balance. With years of unpaid interest accumulating and house prices falling, some homeowners have seen their equity disappear and now owe even more than their initial loan balance.

The loans automatically recast after five years, but many will recast sooner as loan balances hit specific principal caps—typically between 110% and 125% of the initial loan amount. Many of these loans are expected to recast within the next two years, meaning that borrowers' monthly payments will swell to include both principal and interest...

William Purdy, a lawyer at Simmons & Purdy in Soquel, Calif., a firm that specializes in home refinance issues, said some borrowers with option ARMs are defaulting before the loans recast because they couldn't afford even marginal increases in the minimum payments.

"It's a ticking time bomb inside your house that you can't get rid of," Purdy said. "They can try to slow down the inevitable, but sooner or later their loan is going to cap. …This year is going to be a blood bath. Next year, we'll start out just about the same."...

But options are available—even if refinancing isn't possible. Lenders have been working with borrowers to reduce loan amounts and interest rates and, in some cases, simply accept the deed in lieu of foreclosure.

The Mortgage Bankers Assn. says it appears that a growing number of homeowners are avoiding foreclosure by getting help from the Hope Now hotline (888 995-HOPE), a mortgage-counseling phone line backed by lenders and the federal government that gets 4,000 calls a day. Hotline counselors help borrowers negotiate with banks and offer advice on refinancing options. Even though foreclosure rates are rising in California and Florida, they've slowed elsewhere, the bankers association said.

Some callers to the hotline have complained about long wait times, but the group says it has beefed up its counseling staff and now gets to calls quickly.

Other option ARM borrowers could benefit from government plans now in the works. A bill approved by the House in May would allow the Federal Housing Administration to guarantee up to $300 billion in new loans to help homeowners facing foreclosure. Borrowers could get more affordable loans worth no more than 90% of the home's value, meaning that participating lenders would have to take a significant loss on the loan. The bill was sponsored by House Financial Services Committee Chairman Barney Frank (D-Mass.). Senate Banking Chairman Christopher Dodd (D-Conn.) has a similar measure....

Many California homeowners, including some with $2 million homes, are simply making their minimum payment, waiting for the recast. Then they plan to walk away, even if it damages their credit, Bedard said.

Builders might want to plan for fewer retirees than expected

For years, homebuilders and others across the U.S. have been planning for the wave of 78 million baby boomers to retire. However, a Business Week article argues that some of these past estimates have been too optimistic, as a combination of falling housing prices, a bear market in stocks and a gradual reduction in defined benefit pension plans will force many boomers to continue work well into their retirement years:

Companies from cruise lines to retirement communities and financial consultants have been planning for this mass retirement. They hope to profit grandly by selling goods and services to tens of millions of relatively young boomers with bulging nest eggs and decades of free time ahead.

But demography is not destiny—and it may not even make for a good business plan. It looks like fewer of those 78 million will be either rich enough or young enough at retirement to meet the expectations of businesses catering to boomers released from the workforce. This shortfall, and how it may dash such hopes, is the focus of a new study co-authored by Kevin P. Coyne of Atlanta's Coyne Partnership. In coming decades, "the size and growth rate of the U.S. retirement market will be much smaller than is widely believed," he says...

It's the long-term perspective, however, that sets Coyne's analysis apart. He sees permanent shifts taking hold. And the implication is that some portion of the billions companies are spending on services aimed at retirees could be misspent. Experts are bound to disagree on the scale of this investment, but in light of Coyne's report, creators of such services may need to rethink some of their assumptions.

For financial and social reasons, the propensity to delay retirement is increasing, Coyne says. The total number of retirees over the next two decades will grow by less than 3% per year, on par with the overall population, and could fall to as low as 1%, he says. By 2017 this will lead to some 5 million to 10 million fewer retirees than some marketers have been counting on.

Certainly, a shift is under way. In the first four months of 2008, about 30% of 65- to 69-year-olds were either employed or looking for work, up sharply from 24% in the last business-cycle peak in 2000, according to the Bureau of Labor Statistics. Look one rank down, at 60- to 64-year-olds, and 54% are in the labor force, up from 47%.

Social forces are also keeping workers on the job, says Joyce Manchester, an analyst at the Congressional Budget Office. With divorce rates up, more boomers are depending on one income. Many have children just entering college. And a greater number of women now hold white-collar jobs, which are less physically taxing and so easier to stick with than jobs women held in the past. What's more, boomers make up the first generation to fund retirement partly from finite pools of savings instead of wholly from guaranteed-for-life pensions. Says AARP's director of financial security, Jean Setzfand, "That makes them fundamentally more cautious."

Why Fed Chief Bernanke should keep cutting rates

Business Week Chief Economist Michael Mandel argues that Fed Chief Bernanke should continue cutting rates until the financial markets have stabilized:

We live in a boom and bust world—and it’s not the Fed’s fault. As we wait to see what the Fed does on Wednesday, one thing is clear to me: Bernanke and his crew need to keep cutting rates until the economy and the financial markets stabilize, and not worry about the naysayers.

Since the middle of the 1990s, I’ve followed a very consistent theme in my writings. I’ve argued that we live in a high-volatility, high-growth world. High-risk, high-return: The two things go together.

In the second half of the 1990s, we had the Information Revolution, the Internet, and the tech boom. Then we had the tech bust. All told, the combination of boom and bust moved technology—and the economy—much further and faster than pessimists would have predicted in 1995.

Then in this decade we had the China and India booms, along with the housing boom across much of the world. Followed, of course, by the housing bust—but unless the housing bust leads to a megarecession in the U.S., the combination of boom and bust will have moved the global economy much further and faster than pessimists would have predicted in 2001 or 2002.

These booms and busts are not caused by Fed policy, or indeed central bank actions. Rather, they are the natural working out of increasingly efficient financial markets, combined with the much faster transmission of information and ideas across national borders. And these are good things. Over the past ten years, through boom, and bust, and boom, and bust, global per capita incomes have soared...

It is not the Fed’s role to smooth out the boom and bust cycle. The Fed is not omniscient, it does not know what the “right” level for the economy and the markets are. The best that it can do is cushion the damage of the bust, both for businesses and for consumers.

The last 10-15 years have had plenty of minuses. Consumers took on a lot more debt than they should have, perhaps $3 trillion worth. The U.S. lost a lot more manufacturing than it should have. And the Chinese economy is probably shaping up for the mother of all busts after the Olympics.

But none of this can be blamed on the Fed. The central bank needs to take care of its particular responsibilities—taking action to keep the financial system intact. And if that means cutting rates again and again, that’s what it should do.

Much more to the credit crunch than sub-prime loans

There's a review of two different books on the credit crash in the April 28th edition of Business Week magazine: "The Trillion Dollar Meltdown" and "Bad Money." Both books posit that the credit crash is due more to the excess power of Wall Street and the financial community than sub-prime loans, which were merely a symptom of a style of free-market capitalism that got out of control. So what will the consequences be? Certainly some pain -- but not until those in power admit the extend of the problem. From the BusinessWeek website:

Are you confused about how so much American debt could vaporize so fast, threatening to take down the global financial system? Are you wondering what should be done to prevent another systemic crisis in the markets? Are you puzzled over what it all means? Two recent books offer answers to these vital questions. Both place the credit crash in historical context. Each author believes Wall Street and the financial community have far too much power. More controversially, both argue the fallout will result in a dramatic transformation of the U.S. economy. The Trillion Dollar Meltdown by Charles R. Morris deserves a spot on any bedside reading table. Morris, a former banker and sometime writer for The Atlantic Monthly, more than accomplishes his stated goal of telling his story "briefly and crisply." For instance, he manages to make clear both the mechanics of slicing and dicing collateralized debt obligations (CDOs) and why these and similar securitized credits and derivative securities went spectacularly bust. Bad Money by political analyst and author Kevin Phillips is more ambitious, tracing the current "global crisis of American capitalism" to the politics of peak oil, the rise of financial mercantilism, the triumph of market fundamentalism, and even the spread of religious conservatism...

Morris puts to rest any lingering notion that the credit crisis reflects merely an inflated housing market, let alone a simple subprime problem. He estimates that writedowns and defaults of residential mortgages, commercial mortgages, junk bonds, leveraged loans, credit cards, and complex securitized bonds could reach $1 trillion. (The International Monetary Fund recently picked that number for the global write-off.) The figure could double or triple should there be widespread market panic. Little wonder that the Federal Reserve Board has been working so hard to stave off financial contagion...

In essence, Morris traces America's credit madness to the rise of Chicago School free-market capitalism, best represented in the work of late Nobel laureate Milton Friedman. That ideology supplanted Keynesian liberalism, which gave government a key role in achieving low inflation, low unemployment, and fast economic growth...

Now, though, he believes Chicago free-market ideology is washed up, like Keynesian liberalism before it. "The current conservative, free-market cycle...seems to have long since foundered in the oily seas of gross excess," writes Morris.

Beneath the free-market paradigm, three trends conspired to create the great credit bubble. First, residential mortgages, leveraged buyouts, and other loans gravitated away from banks to global capital markets. Second, the securitization of everything meant that lenders ceased to care whether loans were good or not; they thought only about pocketing enormous fees. Third, portfolio managers' increased reliance upon quantification left them with a flawed image of reality—artificially tidy and apparently risk-free. A final culprit: former Fed Chairman Alan Greenspan, whom Morris faults for cheerleading the deregulated financial markets, allowing easy money to flourish, and failing to disabuse Wall Street of the notion that the Fed will always bail out the financial markets...

He also takes a stab at what might come next: a long-term decline of the U.S. economy, especially if political leaders and financial elites try to mask how deep the credit crisis runs. However, Morris holds out hope that better days lie ahead if elites exercise leadership in the mode of '80s Fed Chairman Paul Volcker, who slew inflation and restored trust to the U.S. economy. Nevertheless, Morris anticipates a nerve-wracking denouement...

The debate about the political significance and economic implications of the credit crash are just beginning. To varying degrees, these books stake out the arguments for returning to a world where finance serves society rather than the other way around.

Owning up to the reality of a recession

It's sometimes hard to avoid being frustrated by the various games played by economists and experts with agendas (and how they tend to color their analysis a la the NAR's David Lereah or now Lawrence Yun) but now that a recession seems a foregone conclusion, Business Week writer Peter Coy provides an overview of what ails the U.S. economy and what we might expect the government to do:

How bad will this downturn get? No one can know because we've never experienced such a headlong slide in the housing market—and this comes at a time when its current value of $20 trillion accounts for the vast majority of most families' wealth. Right now most economists expect the U.S. to experience a mild, short recession in 2008. But there is at least a possibility of a steeper decline that the traditional recession remedies—interest-rate cuts here, deficit spending there—won't be able to handle...

Broadly speaking, policymakers have three options for putting a safety net under the economy. Each has its pros and cons, and the cons become most apparent when the measures are taken to an extreme. That's why a three-pronged approach that uses each option in moderation may be the best way to go.

The first option is to depend mainly on aggressive measures by the Fed to flood the economy with liquidity. That's already under way. On Mar. 11, the central bank announced an innovative program to lend $200 billion in high-grade Treasury securities to big commercial and investment banks. It will allow them to use, as collateral for the loans, valuable but harder-to-trade assets such as AAA-rated mortgage-backed securities. The measure could enable them to start lending and borrowing again. The cons: no direct help for distressed homeowners who don't qualify for refinancing.

A second option would be some sort of a government-led bailout of homeowners, which reduces the burden of looming debt and high interest rates, and limits foreclosures. The third option would be assistance to the lenders and holders of mortgage-backed securities in an effort to thaw the credit markets. The trouble is, both of these options are seen as unfair by those who don't require bailouts. And it's up in the air who would have to bear the biggest share of the housing-related losses: homeowners, investors, or taxpayers.

It's indisputable, though, what policy changes cannot accomplish. There's no way to stop home prices from falling; they got way too high, and the current crisis won't end until they get back to what the market concludes is a sustainable level. It's not reasonable to try to avoid a recession, either. When a sector as huge as housing goes into a deep dive, it's pretty much inevitable that the rest of the economy will be affected...

Policymakers have an obligation to make sure the downturn doesn't gather speed and turn into something along the lines of the long and deep 1973-75 recession. It is extremely dangerous for there to be millions of homeowners who have a clear financial incentive to abandon their homes because they are worth less than the mortgages on them. Already there are signs that the stigma of abandoning a home is fading, as desperate homeowners flock to Web sites with names like walkawayplan.com and youwalkaway.com...

The entire capital of the U.S. banking system would be wiped out many times over if everyone who was underwater on a mortgage turned the keys over to their lenders...

There's a social aspect, too. Concentrated foreclosures, voluntary and otherwise, can destroy neighborhoods because abandonment increases decay and crime. And the housing crash undermines the social compact...

The most urgent task is making sure that the financial system isn't so crippled by losses that it ceases to perform its critical function of moving capital from those who have it to those who need it. Asset deflations can damage the financial system. Further complicating matters is that securitization and derivatives make it nearly impossible to figure out who's vulnerable to a big loss until things blow up...

The Fed's approach is double-barreled. Since last summer it has cut the federal funds rate from 5.25% to 3%, and markets are forecasting the central bank will cut to around 2% before it finishes. The Fed may need to go even lower, though, perhaps to 1.5% or even back to its 2003-04 level of 1%...

The Fed's second tactic is to ease the credit crunch by convincing market players that suspect assets really are worth something. It's doing that by giving commercial and investment banks new options for backing up their loans. The Fed's Mar. 11 move is designed to help its primary dealers—20 huge firms at the core of the financial system. They will be able to pledge a wider variety of collateral—including AAA-rated private label mortgage-backed securities—in exchange for top-quality Treasuries. And the loans will be for 28 days instead of just overnight...

But the Fed can't do it alone. Lower rates don't help homeowners who can't qualify for a new mortgage because their homes have lost too much value. Also, massive cuts raise the risk of inflation, which in turn pushes up long-term interest rates, partially neutralizing the Fed's efforts. The Bush Administration's $152 billion economic-stimulus package will help a bit, but economists expect the lift to fade by the end of 2008, not long after the November elections...

But one person's "necessary intervention" is another's "outrageous bailout."

When the government steps in, that's when the battle starts about who wins and who loses. Home mortgages account for 44% of private nonfinancial debt, making them one of the main pillars of the debt market. If the value of household real estate falls by 25%—an amount many economists consider plausible—it would be a $5 trillion loss of wealth. Any type of government bailout plan will alter the eventual distribution of losses between homeowners and investors...

The purest form of bailing out homeowners would be forcing lenders to reduce the amounts borrowers owe. Such a "cramdown" could be accomplished by legislative fiat or, more likely, by changing the federal bankruptcy law to allow judges to reduce mortgage debt in a Chapter 13 reorganization the same way they're allowed to reduce other debts...

The downside: In the short run, lenders might face even bigger losses. In the long run, they would charge higher interest rates for fear of future cramdowns...

At the other extreme are ideas that would bail out the lenders without trying to prop up prices. Harvard's Feldstein, who publicized his plan in a Wall Street Journal op-ed piece on Mar. 7, would have the federal government make low-cost personal loans to families equaling 20% of their mortgage debt. The homeowners who took the offer would have to use all of the money to pay down their mortgages.

That would give a huge shot of cash to lenders and would reduce the likelihood that borrowers would walk away from their homes since the remaining mortgage debt would be well under the home's value. But it would expose taxpayers to risk while doing nothing to reduce the total indebtedness of households. And by letting lenders off easy, it would embolden them to think they could lend irresponsibly again with impunity...

In the Presidential race, Republican Senator John McCain doesn't want to bail out either side, favoring private workouts between borrowers and lenders. Here's how he summed up his feelings on Mar.11: "It is not the government's role to bail out investors...or lending institutions who didn't do their job."

Democratic Senators Barack Obama and Hillary Clinton both tilt toward homeowners, but Clinton is more aggressive, calling for a voluntary 5-year freeze on subprime mortgage rates and a 90-day moratorium on foreclosures...

One idea that's gaining support from some liberals and conservatives alike is the creation of a modern-day version of the Home Owners' Loan Corp., a Depression-era agency that bought mortgages at a discount and issued new, more affordable ones...

Even if the warring parties agreed to such a plan, there would still be plenty of scope for conflict...Each side, naturally, would cloak its arguments in the public interest. Lenders would try to dump the worst-performing loans on the government and retain the healthy ones, notes Elmendorf. And any wide-ranging program would inevitably help many undeserving borrowers and lenders.

One danger is that political brawling will lead the debate away from what's best for the economy as a whole. There are many ways to get this wrong. In Japan in the 1990s, for example, insolvent but politically powerful companies got their banks to keep them alive with low-cost loans, which meant that the banks had no money left over to fund new businesses. That led to Japan's infamous Lost Decade of slow growth.

All that said, some inefficiency and political conflict may be an acceptable price to pay for programs that lessen the very real risk of a systemic financial meltdown.

In other words, there will be plenty of angry renters who sat out this entire boom-and-bust phase waiting for the typical fundamentals to return to the markeplace. But it's not just about them and their dreams for affordable homes, anymore. As part of a society, we sometimes have to hold our noses when we bailout those seen as undeserving.